Heard on The Street

Michael Lewitt
Wednesday, March 1, 2006

From John Mauldin's "Outside the Box":

OVER THE RAINBOW
by Michael E. Lewitt

Feb 27, 2006

General Motors

Perhaps the inevitable General Motors bankruptcy will be the straw that breaks the camel's back. (Accounts managed by Harch Capital Management, Inc. are short both General Motors stock and bonds.) On February 16, 2006, The Wall Street Journal ran an article entitled "GM Debt Poses Challenge to Derivatives Market." "The car maker has about $30 billion in debt. Traders estimate more than $200 billion in credit derivatives are linked to GM. But because such derivatives don't trade on an exchange, nobody knows for certain how much credit default swap protection has actually been written on GM. And nobody can say with confidence that they even know who is on the other side of the trades that they have entered into. Such uncertainty is one reason that, since last year, regulators have asked participants in the fast-growing market to get their operational act together. That encompasses everything from dealing with a backlog of unconfirmed trades to figuring out who their counterparties are when one side transfers contracts to another party...Four years ago, the derivatives market was a fraction of the size of the underlying corporate bond market. Today, it is estimated at $12.5 trillion, more than twice the underlying market's size, and it continues to expand rapidly."

Bill King's view? "The Street better hurry and finalize an agreement to settle GM CDS for cash. If the derivatives market exacerbates a possible GM bankruptcy by some multiple, the numbskulls up on Capital Hill will be forced to act. And those numbskulls will act indignant and assert that they were unaware or misled. And they will look to demonize somebody because the system[ic] problems caused by derivatives could be a multiple of the problem caused by a GM bankruptcy." (The King Report, February 23, 2006) The wise men in Congress may squawk all they want, but they will not be able to say with any credibility that they weren't warned about a GM bankruptcy. Moreover, they may try to point the finger at others, but the policy failures that will have been partially responsible for this sad ending must be laid right at their doors: failed energy policies; failed pension and healthcare policies; failed industrial policies.

And sure enough, another warning was sounded on February 21, 2006, when Moody's Investors Service dropped GM's credit ratings another notch further into junk territory and expressed concern about GMAC's stand-alone rating. Joining Standard & Poors, which had already used the "B" word, Moody's warned that GM could face bankruptcy if it is unable to reduce its costs. "The downgrade reflects increased uncertainty that the company will be able to achieve all of the steps necessary to establish a competitive wage, benefit and supplier cost structure outside of bankruptcy...Moody's remains concerned that in the absence of material progress in reducing its UAW-related cost burden through negotiations, GM could resort to bankruptcy as an option to reduce this burden." GM should heed Moody's warning, and do it sooner rather than later. The unions are going to play this situation out as long as they can, and in the end the result is going to be the same -- the "B" word.

Moody's warning was hardly surprising. A little more unexpected, perhaps, was what the rating agency had to say about GMAC. In a separate statement, Moody's said that the finance company's stand-alone credit rating had weakened from the investment grade level to the mid-Ba level -- a less-than-investment-grade rating. As our readers undoubtedly know, GM has been trying to sell GMAC for many moons, and a transaction announcement has been imminent for so long that it has given the word "imminent" a bad name. The import of Moody's statement, however, was that its analysis of a post transaction, stand-alone GMAC would begin at the lessthan- investment grade level, which could pose a serious obstacle to a transaction that was initially designed to preserve GMAC's investment grade rating and protect the finance arm's rating from GM's deteriorating auto manufacturing business. As one Moody's analyst put it: "The longer the process takes, the more evident it seems that the deal challenges come to the fore." That's another way of saying that when it rains, it pours. In the days after this announcement, GMAC's bonds traded down to a four-month low as investors grew increasingly concerned that a sale of the unit would not restore its investment grade rating.

In the February 20, 2006 edition of Fortune ("The Tragedy of General Motors"), reporter Carol J. Loomis suggests that a GM bankruptcy will be a major event for the U.S. economy and, more importantly, for the U.S. psyche:
"It is the instinctive wish of most American businesspeople, even those unlikely to be directly affected, that General Motors not go bankruptcy. True, some people will say, 'They had it coming to them.' But the majority will be more practical, telling themselves that the company is so central to the economy, so sprawling in its commercial reach, that bankruptcy -- 'going into chapter,' as restructuring folks say -- is ominous almost beyond contemplation. And yet the evidence points, with increasing certitude, to bankruptcy....Bankruptcy isn't going to occur next week. But down the road -- say, past 2006 -- its probability is high."
A GM bankruptcy, which HCM views as inevitable (with Ford soon to follow), will be such a monumental psychological event because it will toll the death knell of the American industrial model. No longer will politicians and business leaders be able to defend a system that includes prohibitively expensive legacy costs (healthcare, pensions), uncompetitive union demands (i.e. work rules, uneconomic wage and benefit packages), and a dysfunctional tort system. It is obvious to a child of elementary school age that the system is broken; it is a true American tragedy that it is going to take the bankruptcy of an American business icon to force the point home. And even then, in today's political and economic system, there is no guarantee that anything more than a band-aid will be applied to the problem while America's industrial system is allowed to slide further into the abyss.

Typical of the "stick your head in the sand approach" approach to the problem is a recent article by Forbes writer Jerry Flint. In a column called "Bankruptcy, Shmankruptcy" (February 13, 2006), Mr. Flint writes: "Enough already on General Motors and bankruptcy. I am tired of the B-word. GM isn't going bankrupt this year. GM isn't going bankruptcy next year; 2008 is so far off that even Bill Gates could be bankrupt by then. It's dangerous to go three years out, but no. I wouldn't expect GM to go bankrupt in 2008, either." Mr. Flint's reasoning is, unfortunately, non-existent. He points to a turnaround at Chevrolet last year -- he reports that it outsold Ford last year. That's like saying that the second-to-last-place team beat the last place team. He points to the $19 billion of cash that the company has on its balance sheet, but he forgets to look at the left side of the balance sheet, where hundreds of billions of dollars of liabilities reside. Finally, he resorts to patriotism: "I've written this before and I'll write it once more. The graveyards, and the ocean bottoms, too, are full of men who underestimated American courage and determinism." HCM is as patriotic as the next guy, but it's going to take more than patriotism to save GM. It's also going to take more than $19 billion, especially when the company is losing billions of dollars a year. HCM is certain that Mr. Flint has the ability to remain optimistic far longer than our readers have the ability to remain solvent if they follow his advice.